Investing in Self Awareness

"Know thyself." -Socrates

Self awareness is increasingly essential to the ethos of many investment companies. That is because active management requires judgment and its exercise is most successful when all the facts and influences are known. As discussed in previous essays, selling is less disciplined than buying and, therefore, is far more susceptible to behavioral influences. In this essay we examine the role of self awareness and its potential for helping you make better sell decisions.

Shooting in the Dark

Self awareness begins with accurate observation. Without adequate information about the decisions they make, managers are severely limited when it comes to assessing their selling. Consider golfing. What if a golfer never knew the accuracy of individual shots? Instead she received only the final score. How would she know her strengths? What part of her game would she choose to improve?

Well this is exactly the dilemma that equity managers face regarding selling. The only feedback most managers receive about their sell decisions comes from total return. And that is all but useless for learning about selling. Lacking measures of sell effectiveness managers must rely on hindsight, intuition and simplistic measures of success to help foster greater self awareness. Authors Childre and Cryer describe the short comings of such an approach this way: "Remember, the mind likes to assume it 'knows what it knows' but often its perceptions are just not accurate."

Memory is Fiction

Reflection is essential to self awareness. But, memory alone is inadequate if your goal is to improve. Much of what our memory provides is a narrative that makes sense out of what we seem to remember about events. And such recollections are heavily influenced by our emotions.

So when we look back over sells for the past year we tend to remember those that had the greatest emotional impact: big winners, big losers, or a string of small gains that kept us pumped up. The feelings that accompany these events make them memorable. No wonder then that hindsight often leads to learning the wrong lessons. False insights are then translated into undisciplined heuristics that diminish sell effectiveness.

A Rule by Any Other Name

Quick decisions in a highly charged environment only partially describes the challenges faced by equity managers. Fortunately nature has endowed us with a powerful brain to help cope with such challenges. One adaptive response we have learned is to use rules or heuristics to guide decision making. Daniel Kahneman, the Nobel Prize winning Psychologist, offers this insight: "When faced with a complex problem, people employ a variety of heuristic procedures in order to simplify the representation and the evaluation of prospects (choices)." But without clear and quick feedback we are just as likely to formulate the wrong heuristic as the correct one. So how does a manager get a better handle on what is behind some of her decisions?

Disciplined investing is not the absence of heuristics. Rather it is the mindful blending of rigor and rules-of-thumb reflecting substantial self awareness. Deep self knowledge provides managers the assurance needed to invoke intuition effectively, whether probing for better sell signals or feeling their way through today's tumultuous market.

Buddha, The Ultimate Alpha Source

An extended stay in the Himalayas might be just the thing to help you develop greater self awareness. But this probably is not a practical option. Yet there are steps managers can take towards financial enlightenment that are simple and effective. Here are two ideas from practitioners.

Be the oracle. Just write down every sell you make and why. Do it at the very time you actually decide. Add a little color, such as: unrealized gain or loss (i.e. looking for The Disposition Effect); recent price movement (i.e. volatility often affects sell decisions); and primary motivation for liquidating the position (i.e. stop loss, target price reached, thesis disproved). Fairly soon you will have data that can help you see patterns in selling that might prompt further investigation or improvements to your discipline.

Suspend judgment. Investment committee meetings often begin with an outpouring of opinions, judgments and aching convictions. Once this highly charged momentum is underway it is difficult to objectively listen to and examine facts. The self aware investor guards against these group dynamics and works to capture maximum insight from diverse perspectives. Try starting your next meeting by suspending the judgments and asking that you and your associates focus only on facts for the initial 15 minutes or so. This will enable all participants to engage in the conversation with a common perspective and to question facts before they become someone’s opinion. A big part of developing greater self awareness is simply making room for it.

Conclusion

Self awareness is a best practice among top investment companies. This softer aspect of investing can help you harden your active management processes. Self awareness is built on three essential elements: 1) the desire to improve, 2) a clear understanding of current circumstances and 3) unambiguous feedback about how any changes you make are working. As you strive for your own self awareness, ask your self this: If selling is ineffective but never measured, is the portfolio's performance really impacted?

References:
1. From Chaos to Coherence: Advancing Emotional and Organizational Intelligence Through Inner Quality Management, by Doc Childre and Bruce Cryer, Butterworth-Heinemann (November 1998).
2. Choices, Values and Frames, by Daniel Kahneman and Amos Tversky, Cambridge University Press.
3. "Yoga Bears: It's No Stretch to Say Traders Are Taking Deep Breaths", The Wall Street Journal, July 24, 2008, Page A1, By Cassell Bryan-Low.